The news feeds this week are abuzz with the fact that the super-rich don’t pay much in the way of income taxes, even as their net worths grow at astronomical rates. In discussing the issue, This CNN article describes a scheme for avoiding taxes that has me scratching my head a bit:
Suppose that in a given year Bezos’ shares rise by $20 billion and, instead of selling those shares, he borrows $1 billion against them to fund his luxurious consumption. He won’t owe or pay a penny of income tax.
OK, Step 1 makes sense: you don’t pay taxes on money received as a loan. But at some point the loan must be paid back, along with interest. The borrower eventually has to get funds for this purpose from somewhere - either from bussing tables (which will require paying income tax), or from selling shares of stock (which will require paying capital gains tax).
What am I missing? How can I fund a billion dollars’ worth of good times without paying any taxes for it?
Borrow a billion from Paul; later, borrow a billion plus a smidge from Peter to pay Paul (while writing off the smidge on your taxes as a deduction); when the time comes, borrow a billion and a smidge and a bit from Paul to pay Peter; lather, rinse, repeat ad infinitum.
Or repeat until death. At which point your heirs will pay an inheritance tax on the total value (unless you structure it as a charitable foundation), but the heirs will receive the shares valued at the current value and the gains during the original shareholder’s life will never be taxed.
I note that this is different in Canada. When you die, the taxman treats all your holdings as having been cashed in at the time of death and all capital gains realized. On the other hand, we have no inheritance taxes.
Basically this. I didn’t think the interest was generally deductible, in the same way that you can’t deduct the interest you pay on your credit card. Are you sure it is?
Although, now that you mention it, I think I reversed engineered the strategy they might be using. If you are correct and my hunch is right, maybe they are converting non-deductible personal interest expense into deductible investment interest expense through what amounts to a sham 1099 exchange. They take appreciated property (Amazon stock, for example) which they 1099 exchange for an interest in an LLP that will hold the stock (and nothing else). They borrow money to acquire additional shares of the LLP from the LLP. They contribute the money to the LLP in exchange for the additional shares. Then they take back the cash as a return of the capital distribution (this is non-taxable). Since the only thing the LLP holds is Amazon shares, and since that has stayed the same after the distribution, the extra shares of the LLP don’t actually have any extra value. On the other hand, because the loan was nominally used to acquire shares in the LLP, it’s a deductible investment interest expense. Do I have it right?
I’m not sure what you mean by “structure it as a charitable foundation.” If you contribute money or property to a charitable foundation, that money is gone because it belongs to the foundation. There are laws against using a charitable foundation’s property for personal use.
Are you referring to placing the holdings in a charitable remainder trust?
That article is hot garbage dressing up his personal opinion as some incontrovertible fact. I could pick it apart line by line but I’m not going to waste my time.
This is true but the lenders aren’t going to lend against 100% of the value of the property and the borrower doesn’t really want to borrow that much. Jeff Bezos doesn’t actually want to sell all of his Amazon stock, in our hypothetical. He just wants a measly billion here and there.
I think depends on our hypothetical billionaire some are well known to be in debt to their eyeballs and inflating their assets value is the only thing that keeps the money rolling. Sure, if you’ve got 200 billion an want a billion to fund this weekend vacation you can roll that forward forever but other billionaires don’t have 200B but want to live the same lifestyle.
Which is why this is a house of cards for everything but the obscenely wealthy and those who - I can’t believe I’m saying this - live within the means of their obscene wealth. If your loans start outweighing your assets, you have a hard time getting loans - and start either inflating your assets or getting your loans from shadier and shadier places, or both. Probably not a concern if you are Bezos or Musk or Warren Buffett.
But if you transfer the shares to the LLP are you not doing the equivalent of selling them, at face value, thus realizing gains.
If you have Amazon that you bought at $100 now worth $1000, then you are either:
-transferring at $1000, so you realized a gain; but now have stock in a company that owns shares valued at $1000.
or:
-transferred at nominal $100 so shared in “Evasion LLP” are only worth $100 each.
So you’re saying the shares are $100, but the LLP prints 9 more and sells them, so now Buffetzos (Bozos?) owns 10 shares worth $100 for a LLP holding a stock valued at $1000. Having sold those shares, the LLP now has cash as well ($900) and distributes that to the shareholder(s)?
Weird that that cash distribution is not taxable, but I guess that’s how it works?
Still, it boils down to leverage. If you have assets worth $1B, and your lifestyle only requires, say, $10M a year, then in less than 100 years you have a problem. Actually, maybe 50 years or so, allowing for compound interest and the income tax due on the sale of the assets at death/inheritance. Assuming the underlying security does not appreciate any in the meantime…
But $10M is $200,000 a week. How much do lifestyles of the rich and famous really cost, considering likely everything including the jet and yacht are leveraged too? A $10M jet paid over 10 years is $1M a year. Unless you really are a jet-setter, you rent or have an arrangement with an operator who rents it out to others too. Typical arrangement with small planes was to lease it to an operator and pay list price for use, in which case it’s an investment and interest is tax deductible… I assume the same can apply to jets; most airlines lease their jets too. If you own the company that owns the building where you have an excessively gold-plated penthouse, lease can be nominal; and again, creates profits you pay to yourself. You might throw the occasional $100,000 party, but most days a round of golf and fancy dinner is only a thousand or two.
And that assumes that you aren’t watching the price of the gazillion Amazon shares you own increase year after year - so people are more than willing to let you borrow more against your increased assets to pay off the last guy you borrowed from.
Fundamentally a loan isn’t viewed as income in a taxable sense.
The article’s author tries to obscure that with some nonsense about how the value of his shares go up in value, and implying that it’s income, but it’s not. It’s just a lazy way of stoking class warfare fires by implying that he’s doing something shady, when he’s not.
But eventually that loan has to be paid back. I think, but am not sure that the idea is that you’ll make more in investment income on that billion you left invested, and instead borrowed for, and that when you DO cash it in, you’ll have made more than the borrowed billion + interest and tax for a net gain, or at least a wash.
Slice-and-dice it any way you like. The bottom-line is the very wealthy have gotten their kind of wealth exempted from taxes while most everyone else has to pay it.
Warren Buffett even admitted as much:
When you (average Jane/Joe) pay more in taxes than Elon Musk does, not just the tax rate but literally the amount of dollars you send to the government, something is wrong.
In a qualifying 1099 exchange, you can trade one investment (like Amazon stock) for a similar investment (like LLC units) without realizing a gain. It’s used in real estate all the time but it can also be used for financial investments.
In a 1099 exchange, you don’t realize a gain but the new property takes the cost basis of the old property rather. So he started with $1000 of Amazon stock with $100 of tax basis (in your example) and winds up with LLC units worth $1000 and $100 of tax basis. Under a 1099 exchange, the tax law pretends that nothing happened. .
No, the process I’m speculating about goes like this:
Bezos has $1000 of Amazon stock.
Bezos contributes the stock to the LLC and receives in exchange 10 LLC units. This is a non-taxable event in a 1099 exchange. The LLC has no activity, assets, or liabilities other than holding the Amazon stock.
Bezos find a bank that’s willing to lend him money to buy more interests in the LLC.
This is an investment expense, so the interest will be deductible.
Bezos borrows $900 from the bank and contributes it to the LLC. This is a capital contribution. In return, Bezos gets 9 more units. He posts all 19 units (100% of the outstanding units) to the bank as collateral on the loan.
The LLC distributes his $900 capital contribution back to Bezos. A return of a capital contribution is not a taxable event. (Imagine for a moment you invested $100 in a restaurant. A year later, they go out of business, wind up their affairs, and return what’s left. By sheer coincidence, you get exactly $100 back. This is not taxable. You have realized no capital gain or loss, and there were no profits to distribute. You just get your own money back. That’s what Bezos is doing).
So now, with the loan, Bezos has realized no gain or loss and he has $900 million in his pocket to spend however he would like. He’ll pay interest on $1 billion and that interest will be deductible against other income.
This makes sense, if you’ve got a single large expense that would require you to sell off investments to raise funds (e.g. to buy a $500M yacht). I could have sold some investments to pay cash for the last car I bought - but instead, I put in a modest downpayment and took out a 5-year loan for the balance. The loan had 2.9% interest, but over the same period the money I kept invested earned an annualized rate of almost 18%, so I came out ahead (and also avoided paying CG taxes by not selling my investment).
It hadn’t occurred to me that a person could take out a loan to pay for living expenses, but I suppose as long as the loan is secured with collateral, you can always find a willing lender. But then living expenses are just an ongoing thing. For covering ongoing living expenses, I can’t see how this sort of scheme would allow someone to come out ahead.
I think this is the crux of the matter, the step-up in basis in an inherited estate, and the aspect of the tax system that should be corrected. If you can defer capital gains tax long enough, the liability for tax vanishes at death - with NO LIMIT to the dollar amount of capital gains tax liability that evaporates. So far as I’m aware, no other developed economy (or at least very few) other than the U.S. have this loophole, which strongly favors retention of vast wealth within economic “dynasties”.
The step-up has some element of logic to it, if it were part of an overall taxation process where cost is set aside, and the entire estate is marked-to-market at death, and some other form of fair estate tax is imposed on the full mark-to-market value. But with other loopholes to avoid estate tax, in practise this doe not happen.
Step-Up in Basis as a Tax Loophole
The step-up in basis tax provision has often been criticized as a tax loophole for the ultra-rich and wealthy. They take advantage of it to eliminate or reduce their tax burden. For example, they can escape capital gains tax on stocks by placing their holdings in a trust fund for their heirs.
A typical scenario might be a millionaire who invests in assets, such as real estate and stocks, that are expected to appreciate. As a result, these assets would provide them with a consistent rate of return during their lifetime. The investor’s heirs will enjoy the benefits of the investment after their death because they will be taxed on the stepped-up cost basis, instead of the original cost. This allows them to evade taxes in the amount of millions of dollars.
The case of the Walton family (the owners of Walmart) is fairly well-known; supposedly, the family has put a majority of their holdings into estates to avoid paying taxes.
At one point, Biden was planning to abolish it. I’m not sure if it’s still in his planned legislation.
My bank offered me a line of credit secured by my investment portfolio. That didn’t really make sense for me, but I can imagine something similar making a lot of sense for someone whose wealth is largely ownership interests in a corporation – you don’t want to sell shares because you don’t want to realize the gain or lose control of the company. So a loan for living expenses might make a lot of sense – of course (and I guess this gets back to the original question), you’d have to earn enough income (and presumably pay tax on it) to make the loan payments.
I notice that the CNNMoney reference attributes to Buffet the statement that his secretary is still paying a ‘higher rate’ — not that his secretary is pay more tax.